States overextend themselves in healthy fiscal times and then rely on national bailouts when the business cycle takes a downturn.
Should a future recession necessitate another round of state-welfare bailouts, the federal government should nationalize currently split entitlement programs.
A merica’s state governments are currently flush with funds and expanding their spending commitments. Congress had provided over $1 trillion in pandemic aid to state governments, fearing that Covid-19 would cause their revenues to collapse and entitlement costs to surge. Yet, state Medicaid spending actually fell as Americans sought fewer elective procedures, while their own-source real tax revenues increased 12 percent on pre-pandemic levels.
This dynamic — of states overextending themselves in healthy fiscal times and then relying on national bailouts when the business cycle takes a downturn — has become characteristic of modern American federalism. Funds are poorly targeted to help those who most need assistance, and destined to fall short during recessions.
Prior to the Great Depression, responsibility for public welfare fell mostly on local government. But as unemployment and relief needs soared and property-tax revenues slumped, states pressed the federal government for aid. With Jim Crow southern Democrats leading key congressional committees, bailing out the states was the main priority unifying the diverse New Deal coalition. From 1932 to 1942, the increase in spending on public welfare through federal grants (from $1 million to $278 million), greatly exceeded that in direct federal spending ($1 million to $158 million), and accounted for most of the surge in state spending on public welfare (from $74 million to $527 million).
This institutional arrangement was expanded in subsequent decades. Medicaid now generally provides between $1 and $3 of federal funds for every $1 that states spend on medical services for eligible low-income beneficiaries, offering them an extraordinarily high return on investment. The states with the broadest tax bases have been able to take most advantage of it: In 2021, oil-rich Alaska received far more in federal Medicaid funding per poor resident ($21,445) than Nevada ($8,402).
Health care now accounts for two-thirds of federal grants to states, and states have become adept at using Medicaid to harvest federal funds. All 50 states now tax hospitals and other medical providers to inflate the matching aid they can claim from the federal government, and often shift the profits to improve their general fiscal situations. When Medicaid caseloads decline during economic upturns, states have tended to expand benefit packages and loosen eligibility criteria — relying on Congress to provide ad hoc bailouts when expenses spike in subsequent recessions.
The federal government requires states to establish their own unemployment-insurance programs to avoid a 6 percent payroll tax. As with Medicaid, this has the effect of enshrining disparities between states, entrenching haphazard state administration, and placing the federal government on the hook when the system runs out of money. Prior to the pandemic, New York had only 36 percent of the recommended amount set aside for recessions in its UI trust fund. Congress has provided additional funds to bail out UI on an ad hoc basis in 1958, 1961, 1971, 1974, 1982, 1991, 2002, 2008, and 2020 — nine of the last ten recessions.
The 1996 welfare-reform law limited payments states could claim under the Temporary Assistance for Needy Families program, but it froze enormous disparities which had previously been established. As a result, federal TANF grants in 2020 ranged from $3,876 per poor child in the District of Columbia, to $276 in Mississippi. But the provision of TANF funds as block grants has freed states to divert them to extraneous purposes (most notoriously, paying Brett Favre for speeches — Favre has denied any wrongdoing), while steering individuals to other means-tested entitlements which are fully funded by the federal government.
State involvement in federal entitlements leads them to bloat without direction or correction, as proposed reforms meet the opposition of governors as well as of beneficiaries. Whereas Congress made substantial cuts to the fully federal Medicare program in 1982, 1989, 1997, 2010, 2011, and 2022, Republicans have labored fruitlessly for three decades to cap the growth of Medicaid payments to states. Even if they were enacted, such caps would likely only increase the risk of Medicaid bailouts.
Should a future recession necessitate another round of bailouts, the federal government should assume full financial and operational responsibility by nationalizing currently split entitlement programs. Federal legislation already mandates most details of basic Medicaid benefits and eligibility, as well as providing 70 percent of funding. Unemployment insurance already gets imperfectly nationalized in recessions, when it is most needed — yet the current system means higher taxes and less aid for those in poorer states and is poorly structured to help people move to where jobs are available.
Unlike expenditures on education, transport, and law enforcement, Medicaid and unemployment-insurance spending soars in recessions and accounts for the bulk of states’ fiscal fragility. Entitlements can be provided most robustly and cost-effectively if they are administered and financed nationally. As with Medicare and Social Security, this would make programs easier for Congress to control, avert the need for bailouts of states in recessions, and eliminate the ability of politicians to overextend programs by shifting costs to taxpayers outside their states.